organizations. This may not necessarily be on cost grounds alone, but to enable management to concentrate on core activities.
When manufactured items are concerned, the decision to outsource is of strategic importance, particularly if it is made before any invest- ment takes place. The advantages of using a contract manufacturer for components or finished products include:
ᔢ reduced investment in fixed assets and working capital;
ᔢ no set-up, development and training costs;
ᔢ commercial risk reduced in uncertain markets;
ᔢ quality assurance to relevant British Standards where appropriate;
ᔢ management freedom to concentrate on marketing and strategic issues.
There can also be a downside. A company’s ability to innovate and develop its product range may be weakened by outsourcing if the necessary know-how is retained by the contract manufacturers. The features of the traditional buyer-supplier relationship is a short-term adversarial one with each trying to get the best price with little sharing of ideas between the two parties.
More recently, the move has been towards partnership sourcing as an alternative to straightforward outsourcing, with a consequent big reduc- tion in the number of suppliers. Key features of partnership sourcing are:
ᔢ long-term relationship;
ᔢ pooling of technical information;
ᔢ sharing of the risks and rewards.
Throughput = Sales revenue – Direct materials Goldratt observed that production capacity was not so much a limiting factor as production bottlenecks (for example a machine) which either reduced the effective capacity or led to a build-up of work-in-progress.
His goal was to maximize the throughput of a factory and to focus atten- tion on managing the bottlenecks.
This could be done by holding buffer stocks in front of the bottle- necks (to ensure continuity of work); to identify rejects before the bottle- neck stage (to avoid wasted effort); to concentrate new investment on removing the bottleneck or lessening its impact. At a later stage, Goldratt widened his interest from bottlenecks to any constraint that limited the achievement of goals. He argued that any improvements other than on constraints or bottlenecks would not lead to increased throughput.
Throughput can be used to measure progress towards the removal of a bottleneck. It should be recognized that once one bottleneck is removed another scarce resource will likely take its place as the new bottleneck.
Goldratt took issue with cost accounting and thought it the enemy of productivity. His reasoning was that under absorption costing, over- heads are borne by goods going into stock and work-in-progress just as much as they are borne by goods that are sold. Goldratt’s emphasis on maximizing throughput is, by definition, concerned with sales as opposed to production. This point can be illustrated by looking at Figure 13.10a later where all overheads (and direct labour) are treated as opera- tional expenses and charged against sales. Any stocks and work-in- progress carried over a period end are valued at material cost only under throughput accounting, so there is no incentive to boost stocks as they carry no overheads and, therefore, do not affect profit.
Another term used by Goldratt is inventory. This might appear some- what misleading as the term is used to embrace both stocks and fixed assets. In other words, inventory here means the total capital invest- ment. The concept of return on inventoryis therefore akin to return on investment or return on capital employed.
Operational expensewas the name he gave to the money spent on all non-material costs and includes all labour and production overheads.
So we can say in Goldratt terminology that:
Marginal costing
Net profit = Throughput – Operational expense and also that:
Return on investment = Throughput – Operational expense Inventory %
Goldratt again might seem at odds with cost accounting with his emphasis on increasing throughput rather than controlling costs, reduc- ing operational expense and reducing stock levels. He is in tune though with the rationale of just-in-timeand total quality managementin that both these practices should also result in increased throughput.
Primary ratio
Apart from introducing us to the term throughput accounting, Galloway and Waldron produced a number of ratios used to measure factory performance, departmental performance and a means of placing products in rank order.
A primary measure of manufacturing performance relates throughput (sales less material costs) to total factory costs excluding materials costs. A ratio greater than unity is needed for the business to be profitable.
Primary ratio = Throughput Total factory cost
Secondary measures are used to relate throughput to a scarce resource to identify the amount of throughput per unit of resourcein a not dissimilar way to that described earlier when discussing contribution per unit of scarce resourcefor ranking purposes.
Comparison of throughput accounting with marginal costing
The similarity of throughput accounting and marginal costing is evident in other ways. If we compare their respective definitions, we find:
Throughput = Sales – Material costs
Contribution = Sales – Variable costs
The difference between throughput and contribution definitions lies in the fact that material cost is a variable cost, but the latter may also include some labour and overhead costs. Throughput deducts only material costs from sales whereas contribution deducts all variable costs from sales. This is evident when we contrast a throughput profit and loss account with a marginal costing profit and loss account as shown in Figures 13.10a and 13.10b.
£000
Sales 4,000
Direct material cost of sales 1,500
Throughput 2,500
Operational expense (all treated as fixed costs) 1,800
Profit 700
Figure 13.10a Throughput profit and loss account
The difference is in the treatment of direct labour and variable over- heads. In throughput accounting these are treated as fixed costs and included in operational expense. They are not deducted from sales to arrive at throughput. In marginal costing these items are treated as vari- able costs and are deducted from sales before calculating contribution.
£000
Sales 4,000
Variable costs 2,200
Contribution 1,800
Fixed overheads 1,100
Profit 700
Figure 13.10b Marginal costing profit and loss account
There is no difference between the final profit in Figures 13.10a and 13.10b. In each case it amounts to £700,000. The two profit and loss accounts bring out the difference between throughput and contribu- tion caused by the inclusion of £700,000 direct labour and variable over- heads as variable costs in Figure 13.10b.
Marginal costing
Further reading
Drury, C (2004) Management and Cost Accounting, Thomson Learning, Stamford, CT.
Gowthorpe, C (2005) Management Accounting for Non Specialists, Thomson Learning, Stamford, CT.
Self-check questions
1. Draw a break-even chart to decide from which firm you would hire a car. Firm A charges £50 per day plus 28p per mile while Firm B charges £36 per day plus 40p per mile.
2. Draw the break-even chart shown in Figure 13.3 and read off the amount of profit made when output equals 18,000 units.
3. Referring to the information in Figure 13.7, would you advise the directors of Imet Ltd to discontinue product C if they could use the same resources to produce 80 per cent more of product A? (Assume same cost and selling price per unit.)
4. Your repair yard has been asked to tender for an immediate repair to a damaged ship, which will provide work for the next few weeks.
The yard is short of work, with many workers idle, although being paid a guaranteed wage. You have heard that another firm has already tendered on the basis of direct costs only, without any contribution to overheads or profit. Will you still put in a bid? Give reasons for your answer.
5. A firm sells a product for £25 which has a variable cost of £14. Fixed overheads amount to £800,000 in total and the firm requires a return of 20 per cent on the £1.5 million capital employed. How many prod- ucts need to be sold?
6. A firm has sales of £200,000, £300,000, and £400,000 for its three product lines X, Y, and Z and variable costs of £100,000, £180,000, and
£280,000 respectively. Owing to a skilled labour shortage, produc- tion will have to be cut back next month to the 650 hours that will be available. The three product lines currently consume 350, 350, and 300 hours respectively. Advise the firm on the most profitable product mix to adopt until full production can be restored.
7. Assuming cost is the sole consideration, when is it preferable to buy- in rather than source internally?
8. What is meant by throughput?
9. What is the difference between throughput and contribution?
10. What performance indicator would you use to measure changes in throughput efficiency?
Marginal costing
Standard costing
INTRODUCTION
Cost information can be used equally in a forward planning context as in an examination of past events. Standard costingis a control technique which compares standard costs and revenues with actual results to obtain variances which are used to stimulate improved performance (CIMA). The standard cost of a product (or service) is the total cost of labour, materials and overhead apportionment that should be incurred in the production process.
When production takes place the actual costs of the batch are compared with the predetermined standard cost for that quantity.
Inevitably differences, now called variances, will occur and these are examined for their causes in order to improve future performance.
Figure 14.1 illustrates this sequence of events as a control cycle.
1 2
Setting new standards Measuring actual
of performance performance
4 3
Taking corrective Comparing actual action if necessary with standards
14
Firms use standard costing techniques for a variety of reasons:
1. The actual setting-up of the standard cost specification involves determining the most suitable materials and methods of operation from the viewpoints of both firm and consumer.
2. Once set, a standard becomes a yardstick against which perform- ance can be measured.
3. Standard costing also engenders cost consciousness in employees who know that costs are being monitored, and, it is hoped, acts as a motivator if the standards are realistically set.
4. Top management can stand back from the day-to-day management which they can delegate and control by requiring explanations only of significant variances from standard.
5. Finally, a standard cost is a firm base from which to price products, set budgets and value stock.